The international banking community adopted the Bank for International Settlements (BIS) Basel II Accord as an update from the original Basel I accord written in 1975. This accord comprises recommendations on banking laws and regulations issued by the Basel II Committee on Banking Supervision. It also seeks to halt an erosion of capital standards in international banking systems. The provisions of Basel II align regulatory requirements with economic principles of risk management. This includes defining the international standards of minimum capital requirements for banks to set aside to guard against market risk, credit risk as well as operational risk.
Operational risk can be defined as the risk of loss resulting from inadequate or failed internal processes, people and systems, or from external events. This definition includes legal risk (including fines, penalties, punitive damages resulting from supervisory actions and private settlements) but excludes strategic and reputational risk. Operational risk events are separated into seven categories: 1) internal fraud; 2) external fraud; 3) employment practices and workplace safety; 4) clients, products and business practices; 5) damage to physical assets; 6) business disruption and system failures; and 7) execution, delivery & process management. Traditionally, banks and other financial institutions assessed their own operational risk in each category and calculate the capital reserve needed to cover any operational risk.
Recent regulations prescribe various standards for operational risk management for banks and similar financial institutions and give guidance for the Capital calculation for operational risk as well as requiring banks to develop internal systems to assess operational risk. The regulations allow some banks using the Advanced Measurement Approach (AMA) method of capital calculation for operational risk the flexibility to drop below the minimum requirements of capital-to-risk-weighted asset levels if they are able to meet certain requirements set forth by the Basel II regulation. Under the June 2006 Basel II Revised International Capital Framework, available at http://www.bis.org/publ/bcbsca.htm and incorporated herein in its entirety by reference, a financial institution must hold capital against operational risks. The bank may obtain a reduction of up to 20% of identified regulatory capital if it can adequately demonstrate the transfer of risk. Redeployment of the capital reduced may be conducted at the discretion of the bank. Accordingly, a financial institution in such circumstance can invest up to 20% of their operational risk capital instead of holding it in reserve. In addition, this regulation presents an opportunity for insurance companies to offer new operational risk insurance products to provide such capital relief to financial institution clients.